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Delaware and the Myopic Nature of a "Neutral" Board: In re KKR Financial Holdings

The business judgment rule represents an over-inclusive protection designed to protect risk taking by directors. Boards know that even if they take risks that in hindsight prove to be mistaken and harmful, they will escape liability. The presumption is not, however, designed to protect decisions arguably motivated by a conflict of interest. The judicial erosion of fiduciary duties by the Delaware courts was on display in In re KKR Financial Holdings.   

In that case, KKR formed KKR Financial Corp., a Maryland real estate investment trust. The "primary asset [of KFN] was a portfolio of subordinated notes in collateralized loan transactions that financed the leveraged buyout activities of KKR." The duties of KKR Financial were ultimately assumed by KFN. KFN in turn assigned the day to day management duties to KKR Financial Advisors LLC. KKR, however, owned less than 1% of the shares of KFN. Moreover, the operating agreement for KFN provided that "the business and affairs of [KFN] shall be managed by or under the direction of its Board of Directors." The board of KFN contained 12 directors, two of whom were described as "high-level KKR employees".    

Ultimately, KKR sought to purchase KFN. The board formed a "transaction committee" After back and forth negotiations, the committee recommended approval of the merger. The board met and, with the two "high level KKR employees" excluded, voted to approve the merger.   

Plaintiffs challenged the transaction and argued that KKR "controlled" KFN. As a result, the applicable standard of review should be entire fairness. In rejecting that assertion, the court had this to say:  

  • In my opinion, the allegations of the complaint do not support a reasonable inference that KKR was a controlling stockholder of KFN within the meaning of this Court’s precedents. Although these allegations demonstrate that KKR, through its affiliate, managed the day-to-day operations of KFN, they do not support a reasonable inference that KKR controlled the KFN board—which is the operative question under Delaware law—such that the directors of KFN could not freely exercise their judgment in determining whether or not to approve and recommend to the stockholders a merger with KKR.

The analysis was no surprise. While REITS are typically dependent upon their advisor, KFN carefully preserved the legal authority of the board to oversee the activities of the advisor. Moreover, with less than 1% of the shares, KKR did not have the ability to legally control the board.

What the court ignored, however, was the presence of a potential conflict of interest within the board room.  The board of KFN excluded from approval of the merger the two KKR employees. Nonetheless, the court noted that, based upon plaintiff’s allegations, it was “reasonably conceivable that two other directors . . . would not be found independent of KKR.” One had “longstanding ties to KKR and, among other things, served as a Senior Advisor to KKR and as Chairman of KKR affiliate . . . at the time of the merger.” The other was the dean of a business school “which recently received a $100 million donation from KKR co-founder Kravis, an alumnus.” 

The court went on to determine whether a majority of the board lacked independence and concluded that it did not.  As the court determined:  “I conclude that plaintiffs have failed to allege facts that support a reasonable inference that eight of the twelve KFN directors, constituting eight of the ten who voted on the transaction, were not independent from KKR. Thus, plaintiffs have failed to rebut the presumption that the business judgment rule applies to the KFN board’s decision to approve the merger.”

In other words, as has been discussed before (see Returning Fairness to Executive Compensation) the Delaware courts have created the fiction that boards with a majority of independent directors essentially expunge the taint of any conflict that arises from the presence of directors who are interested or lacking in independence. Having expunged the taint, the applicable standard becomes the all but impenetrable duty of care and the business judgment rule. 

The approach is inconsistent with the theory behind the business judgment rule. As discussed in Returning Fairness:

  • The business judgment rule represents an over-inclusive protection designed to protect risk taking by directors. Boards know that even if they take risks that prove in hindsight to be mistaken and harmful, they will escape liability. The presumption is not, however, designed to protect decisions motivated by a conflict of interest. 

Where potential conflicts of interest exist in the decision making process, which is when there are directors participating in the debate and voting on the final resolution who are arguably interested or not independent, the application of the business judgment rule and a presumption of fairness is inappropriate. In those circumstances, the presumption may be protecting risk taking or it may be protecting a decision influenced or motivated by the interests of the directors allegedly lacking in independence. 

Yet in Delaware that ship has sailed. It is so well established that boards get the presumption of the business judgment rule so long as they have a majority of disinterested and independent directors that the matter was not even discussed in In re KKR


SEC Commissioner Once Again Bemoans Conflict Minerals Disclosure Mandate

From the moment the SEC was charged with drafting disclosure regulations to implement Dodd-Frank Section 1502 (the conflict minerals provision) members of the agency have voiced their unhappiness with being handed the task.  At a recent speech at Fordham University School of Law SEC Commissioner Gallagher once again bemoaned the mandate, along with others.

  • To be blunt, many, if not most, of the 100 mandates imposed upon the Commission by the Dodd-Frank Act do not by any measure represent the best use of the Commission’s time and resources.  Most obviously, whether one views the SEC as a disclosure agency or an enforcement agency, sociopolitical issues such as conflict minerals and extractive resources, while perhaps worthy of attention by the right entities, should not be part of the SEC’s agenda.  Rulemakings for such issues contribute neither to the maintenance of fair, orderly, and efficient markets, nor the facilitation of capital formation, nor investor protection.  They are the creations of special interest groups every bit as strong as K Street lobbyists, and they severely sap the finite bandwidth of the SEC.  As Chair White rightfully noted in this very same venue last year, “[T]he independence of the agency . . . should be respected by those outside, including the industry, other agencies, Congress and the courts.  That independence – and the agency’s unique expertise – should be, for example, respected by those who seek to effectuate social policy or political change through the SEC’s powers of mandatory disclosure.”

Commissioner Gallagher suggests that “[c]ritics of the SEC should focus their attention on whether the SEC is tasked with the right duties.”  But is isn’t criticism of the SEC that leads many, myself included, to argue that conflict minerals disclosure should not be regulated by that agency.  As noted by Commissioner Gallagher “the SEC faces a crushing burden of Congressional mandates that will interfere with our blocking-and-tackling work for years to come if we let them….“Why isn’t there more scrutiny of how we spend our time?”

The real question is one of allocational efficiency and agency competency.  Why do all the vast majority of disclosure regulations seeming automatically get placed on the SEC’s agenda?  It is certainly true that the agency has strong competencies in the disclosure realm—but only when such disclosures pertain to its core mission—that of maintaining free and fair markets.  Social and political issues are not with the purview of the SEC and they are not the best suited to regulate them—despite constant pressure on the agency to do so—pressure that is currently being strongly exerted in the area of corporate political spending. 

Commissioner Gallagher proposes some solutions to the problem of overburdening the SEC.

  • First, we need to affirmatively engage Congress and the Administration and work with them to remove the useless or counterproductive elements of the Dodd-Frank Act.  The emphasis is on affirmatively engaging – we cannot remain passive observers, speaking only when spoken to by policymakers, and expect to succeed in reforming Dodd-Frank.  Second, we need to become a savvier agency – specifically, an agency that serves as an efficient overseer of the capital markets and an aggregator and analyzer of critical market information through the better use of technology.  Finally, we need to affirmatively engage other regulators and relevant policymakers in the critical policy debates of the day – and for that matter, of the past five years.  I have been doing so since the beginning of my term and have found that most stakeholders are receptive to our participation in such debates.  We can learn from their perspective, and they from ours.

These are not radical suggestions—but if the convolute history of the conflict minerals rule is any indication, they are not likely to come to fruition any time soon.


Fee Shifting Bylaws: Strougo v. Hollander (Part 2)

The complaint sets out the text of the bylaw adopted by First Aviation that is being challenged in Strougo v. Hollander. The bylaw provides: 

  • Section VII.8. Expenses for Certain Actions. In the event that (i) any current or prior stockholder or anyone on their behalf (collectively a “Claiming Party”) initiates or asserts and (sic) claim or counterclaim (collectively a “Claim”), or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Corporation or any director, officer, assistant officer or other employee of the Corporation, and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party has a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the Corporation and any such director, officer, assistant officer or employee for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the parties may incur in connection with such Claim. 

The bylaw is relatively typical. It applies to any current or prior shareholder and anyone acting on their behalf. The bylaw also requires a shifting in any claim or counterclaim and is not limited to derivative actions. Finally, the bylaw provides for a shifting of fees unless the plaintiff obtains a judgment on the merits that "substantially achieves" the full remedy sought (something described by the plaintiffs as an "impossibly high standard of success").    

Primary materials, including the complaint, can be found at the DU Corporate Governance website.


Fee Shifting Bylaws: Strougo v. Hollander (Part 1)

As the Delaware legislature continues to remain inactive with respect to fee shifting bylaws, the next move looks to come from the courts. 

The case where this is currently most likely to occur is Strougo v. Hollander. The complaint in the case alleged a breach of fiduciary duty arising out of a reverse stock split. The transaction was announced on May 16, 2014. According to the complaint, the transaction was consummated on May 30, 2014 and a fee shifting bylaw adopted on June 3, 2014. As the complaint states:

  • Bylaw VII.8 was adopted on June 3, 2014, following the announcement of the Transaction, to deter stockholders such as Plaintiff from pursuing litigation challenging the Transaction. The Bylaw imposes an obligation on Plaintiff to pay “for all fees, costs, and expenses of every kind and description” incurred by defendants if Plaintiff fails to “obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.” First Aviation Bylaws VII.8.  

Because the company is not public (it deregistered as a public company in 2007), there is no obligation to make bylaws or changes in the bylaws public. See Item 5.03 of Form 8-K (requiring amendments to bylaws to be filed within four business days). As a result, shareholders alleged that they were unaware of the bylaw until after a suit challenging the fairness of the stock split was filed.  

Again, according to the complaint:    

  • No public announcement has been made notifying First Aviation stockholders about the existence of a fee-shifting provision, nor has the text of the Bylaw been made publicly available to First Aviation’s stockholders. Plaintiff’s counsel was only allowed access to the text of the Bylaw after Plaintiff caused formal discovery requests to be served on defendants. . . . Plaintiff discovered the existence of the Bylaw shortly after filing this action, when counsel for defendants contacted Plaintiff’s counsel and announced that the Board had adopted a fee-shifting provision.

The complaint also alleges that the bylaw "was adopted to discourage litigation challenging the Transaction." Or as the complaint provides: 

  • It is obvious from the timing of this Bylaw that it was adopted with the goal of stifling litigation arising out of the Transaction. The Bylaw was enacted on June 3, 2014, mere weeks after First Aviation publicly announced the Transaction in a press release on May 16, 2014. Further, it is entirely possible that the Bylaw was adopted after Plaintiff spoke with a member of the Board and expressed his discontent over the Transaction. The Bylaw was not voted upon by First Aviation stockholders. In fact, it was never even publicly announced to First Aviation stockholders. Plaintiff only learned of the Bylaw when defense counsel threatened Plaintiff’s counsel with the Bylaw after Plaintiff filed the instant action. Plaintiff and his counsel were only able to obtain a copy of the Bylaw after serving a formal discovery request on Defendants and their counsel.

The timing of the bylaw may affect the analysis. In Kastis, it was clear that the timing of the bylaw mattered (although the bylaw was adopted after litigation commenced). To the extent that the court does take into account the close proximity of the bylaw to the challenged transaction, the effect will be to encourage even more companies to adopt fee shifting bylaws. They will know that for litigation purposes its better to have them in place as a prophylactic, well before any possible decision or transaction that can be challenged.    

Primary materials, including the complaint, can be found at the DU Corporate Governance website.


Cost of Compliance with SEC Conflict Minerals Rule High—Even If Not As High As Feared

According to a survey recently issued by Tulane University's Payson Center for International Development, issuers spent more than $700 million to comply with Dodd-Frank Section 1502 and the SEC's conflict minerals rule promulgated thereunder. The survey was based on responses from 112 of the 1,300 issuers that filed Form SD (the form on which conflict minerals disclosures must be made). These costs break down as follows: 

Total compliance cost for issuers

•The total aggregated and extrapolated expenses of the 1,300 issuers to comply with Dodd-Frank Section 1502 was $709.7 million by June 2014.

•Thus, on average, an issuer expended $545,962 to comply with the law.

$ value

A. Internal company time


B. Non-IT related external resources


C. IT gap / needs analysis


D. IT project element supporting conflict minerals traceability processes and reporting


E. Independent Private Sector Audit (IPSA)


Total  $709,751,142


These numbers are interesting as it appears that despite the allegation made in the original suit challenge the SEC’s conflict minerals rule that the agency failed to conduct an appropriate cost-benefit analysis, the SEC actually came quite close—far closer than Tulane’s original estimate. At the time of original prognosticating, Tulane assessed the costs of implementation to be approximately $7.93 billion—more than one hundred times greater than the estimate prepared by the SEC of $71.2 million (the lowest estimate was $387 million). Why such a differential in the original cost estimates and the final actual costs? In part, it might be explained by the fact that many issuers simply stated their products were “DRC conflict undeterminable” or it may be that the SEC was just right. Regardless, it cannot be denied that the aggregate cost is large—and of questionable impact.

The survey also asked issuers whether they would like to see any changes made to either Section 1502 or the conflict minerals rule to which 65% said yes, 4% said no and 31% had no comment. Included in the changes issuers would like to see are: 


stipulate a de minimis exemption

clarify rule

focus on importation of 3TG

render disclosure voluntary

offer supply chain degree threshold exemption

extend indeterminable period

provide information on and certify SORs

align with the EU proposed legislation

promote standard process and systems across industry

remove audit requirements

expand scope to include diamonds

remove mandatory disclosure 

Given that the conflict minerals rule is still under challenge it is possible that some of the items on issuers’ wish lists will be met. It is not likely however that most of them will as the only portion of the rule not upheld was the requirement to label products as being “non-conflict free.”


Comment Letters in Favor of the Proposed Rule Mandating Disclosure of Corporate Political Spending

We are discussing possible Rulemaking Regarding Mandated Disclosure of Corporate Political Spending.

In August of 2011 the Committee on Disclosure of Corporate Political Spending (“Committee”) submitted a Petition for Rulemaking (“petition”) to the Securities and Exchange Commission (“SEC”) (the petition is available here). The petition sought rulemaking to require public companies to disclose to shareholders the use of corporate resources for political activities. The Committee’s petition focused on four justifications for the proposed rule: first, in response to changes in investor interests and needs, the SEC’s disclosure rules have evolved over time; second, data shows that public investors have become increasingly interested in receiving information about corporate political spending; third, a large number of public companies have voluntarily adopted policies requiring disclosure of political spending; and fourth, the importance of disclosing political spending for promoting corporate accountability. The petition concluded with preliminary comments about the design of the proposed disclosure rules. 

In response to the Committee’s proposal, the SEC received over one million comment letters, most of which were in favor the proposed rule. One such letter was written on behalf of the American Federation of Labor and Congress of Industrial Organizations (“AFL-CIO”) (the letter is available here). AFL-CIO pointed to the fact that, under the federal Labor-Management Reporting and Disclosure Act, the AFL-CIO, its affiliated unions, and thousands of their state and local affiliates are required to produce itemized reports disclosing political spending on an annual basis. In addition, federal and state lobbying laws require a certain measure of public disclosure regarding corporate and union spending on lobbying, additionally federal, state, and local campaign finance laws generally require certain categories of political spending to be disclosed by unions and businesses. On the other hand, despite the “critical importance” to shareholders and corporate accountability in general, AFL-CIO pointed out that “[n]o law requires corporations to disclose to their shareholders whether corporate funds have been spent in connection with candidate elections, ballot measures or direct or grassroots lobbying, or donated to other organizations that use those funds for any of those purposes.”

Moreover, AFL-CIO stated that without a rule mandating disclosure, there is a loss of accountability and an inherent risk to shareholders. This is because “[s]enior management and directors may allow their personal political preferences to motivate and influence decisions on corporate political spending, with inadequate regard for their obligations to shareholders and the company’s own success.” Furthermore, shareholders do not have the resources to access information about corporate political spending decisions on their own. AFL-CIO also asserted that the “absence of a uniform and comprehensive disclosure requirement may mislead shareholders about their companies’ political expenditures.” 

AFL-CIO also discussed the Citizens United decision and how it impels the need for prompt disclosure. In Citizens United the Supreme Court eliminated restrictions on independent expenditures by corporations in political campaigns. By doing so, AFL-CIO argued, corporate political spending has predictably increased, which in turn creates an even greater need for disclosure.

AFL-CIO concluded with a discussion of the possible scope of disclosure that should be required. Due to the need for shareholders to have a complete picture of political spending by public companies, AFL-CIO suggested that, in addition to what is already subject to public reporting, the SEC should consider requiring: (1) companies to report their voluntary donations to other entities that engage in political and lobbying activities under certain IRC and IRS provisions (specifically, AFL-CIO pointed to IRC Sections 501(c)(4) and c(6), and IRS Section 527); (2) companies to report their grassroots and direct lobbying spending, whether or not they are subject to disclosure under federal or state lobbying laws; and (3) companies to report all other payments to other entities and individuals that are earmarked for any of these purposes.  

Another letter in support of the proposed rule mandating disclosure of corporate political spending was sent on behalf of the International Brotherhood of Teamsters (“BT”) (the letter is available here). Like AFL-CIO, BT pointed to the need for unified disclosure, and to the fact that there is no federal system that requires political disclosure for publicly traded corporations. However, BT also discussed the tangible and significant financial impact of increased corporate political spending on investors. It asserted that the lack of federal disclosure requirements “leaves investors with few options for determining if a corporation is even adhering to its own self-imposed rules in the first place.” For example, despite FedEx’s “company policy” not to make corporate contributions to groups organized under Section 527 of the Internal Revenue Code with a few exceptions—a policy that was reiterated in a recent proxy statement opposing a shareholder proposal to require disclosure of all political spending—FedEx “made contributions to at least three additional § 527 organizations between 2011 and 2013, totaling $63,400.” Absent disclosure requirements, shareholders are misled and prevented from taking any corrective action when this type of conduct occurs. BT stated that “[i]nvestors should not have to wait for fallout from poor political or advocacy investments in order to hold their corporate governors accountable. They should have the tools to make these investment decisions from the outset.”

BT also proposed that, in order to “effectively identify the business vulnerabilities created by political spending, strong disclosure should be required across all fronts of corporate political activities.” Just as AFL-CIO suggested, BT recommended that disclosure policies include not only direct political spending, “but all issue-based lobbying undertaken on a corporation’s behalf.” Additionally, it requested that the SEC “specifically consider requiring public companies to report their voluntary donations to all other entities that engage in political and lobbying activities under IRC Sections 501(c)4 and c(6), as well as under IRC Section 527, which covers all ‘political organizations’ regardless of how and whether they otherwise register or report their activities.” Finally, BT noted, just like AFL-CIO, the increased need for disclosure requirements post Citizens United


Opposition to Proposed Rulemaking Regarding Mandated Disclosure of Corporate Political Spending

We are discussing possible Rulemaking Regarding Mandated Disclosure of Corporate Political Spending

On August 3, 2011, the Committee on Disclosure of Corporate Political Spending, comprised of ten academics focusing their careers on corporate and securities law issues, called on the SEC to adopt rules requiring public companies to disclose corporate political spending (petition available here). Despite the overwhelming support of the rule, no action has been taken in over three years. According to Bloomberg, on September 4, 2014, the Corporate Reform Coalition renewed the call to the SEC to engage in rulemaking on the matter.  

While the SEC has received over one million comment letters in support of the rule, there are some who stand firm in their support of corporate personhood. Many organizations, including the National Mining Association, the Small Business and Entrepreneurship Counsel, and the Aircraft Owners and Pilots Association, came together to submit one comment letter opposing the rule. Likewise, the American Petroleum Industry (“API”), “the largest trade association for the oil and gas industry in the United States,” has submitted a comment letter expressing opposition to the rule.

The organizations submitting the joint comment letter claim that the rule has no direct impact on shareholder value. Specifically, they claim that fiduciary obligations require corporations to speak out against government policies that could impact the company financially. Like individuals, corporations engage in political activity in order to protect their interests. The disclosure is immaterial, the organizations claim, because it would allow corporations to be attacked for acting in the best interests of shareholders through political contributions. Likewise, these organizations assert that the disclosure is immaterial such that the SEC has no authority to mandate such disclosure.

The organizations also claim that the cost of compliance is significant for both corporations and investors. The disclosures are likely to be used to attack the companies and pressure them to stop engaging in political spending, even where such spending is in support of policies that will benefit the company in the future. The organizations claim that the rule would violate the First Amendment by curtailing corporation’s freedom of speech as recognized by the Supreme Court in Citizens United v. Fed. Election Comm'n, 558 U.S. 310 (2010). API agrees with this position, arguing that shareholders have the right to engage in corporate governance through shareholder proposals. It states that while this right should not be curtailed, mandating disclosure of corporate political activity is entirely at odds with the holding of Citizens United.

The API letter claims that mandated disclosure of corporate political spending is “neither necessary nor desirable and would burden corporations without benefiting shareholders.” In support of its claim that the rule is unnecessary, API discusses the adequacy of existing political spending disclosure requirements. For example, the Federal Election Commission (“FEC”) requires that any “independent expenditure” or “electioneering communication” by a corporation be disclosed to the FEC and subsequently posted on the Internet. Further, all states require some sort of disclosure of corporate political contributions, and many states impose limits on such contributions. Therefore, SEC regulations regarding corporate political spending would be duplicative.

In addition, API expressed concern with the complexity of such disclosure, including the petition’s silence as to what constitutes corporate political spending. If the definition of political spending includes contributions to trade associations, such associations may be subject to “political or economic retaliation for expenditures unrelated to political activity.”

API further maintained the position that adoption of such a rule was premature considering the Shareholder Protection Act, which would have required shareholder approval for political spending, was on the floor of both the Unites States House of Representatives and the Senate.

In sum, many corporations argue that they will be negatively impacted by the adoption of a rule requiring disclosure of corporate political spending. Not only would such a rule curtail freedom of speech, they argue, but it would also impose unnecessary burdens that would discourage companies from advancing governmental policies that would enhance profit-making capabilities—which benefits shareholders. Further, they argue, corporate political spending is already regulated such that any additional rulemaking by the SEC is unnecessary and duplicative.


SEC Rulemaking: Mandatory Corporate Political Expenditure Disclosures Are Invisible

On August 3, 2011, the Committee on Disclosure of Corporate Political Spending, composed of academics, submitted a petition to the Securities and Exchange Commission (“SEC” or “Commission”) requesting that the Commission develop rules requiring public companies to disclose corporate political expenditures. The petition suggested that through required political expenditure disclosures, shareholders can “ ‘determine whether their corporation’s political speech advances the corporation’s interest in making profits,’ and discipline directors and executives who use corporate resources for speech that is inconsistent with shareholder interests.”

The issue with regulating corporate political spending arose after the Supreme Court issued its opinion in Citizens United v. Federal Elections Commission, 558 U.S. 310 (2010), which lifted restrictions on corporate political expenditure. The Court noted, however, that the “[g]overnment may regulate corporate political speech through disclaimer and disclosure requirements,” and that today’s advanced technology would allow prompt disclosure to shareholders and the public. Such disclosure would provide transparency for the electorate to make informed decisions as well as accountability to the shareholders with respect to whether the political expenditures are in the corporation’s best interests.

According to Bloomberg, the SEC has received over one million comments in support of the political spending disclosure rule. Most commentators to the petition have responded by emphasizing the utmost importance of public disclosure in carrying out the SEC’s mission to maintain fair markets and protect investors. Recent anonymous comments highlight the Court’s suggested government regulation through disclosure and requested the Commission to enact a political spending disclosure rule.

The Commission has yet to consider the political spending disclosure rule. The Commission did at one point indicate that a possible rule was on the Commission’s long term rulemaking agenda. The Commission, however, removed the subject from the rulemaking agenda a year later.

According to Reuters, SEC Chair Mary Jo White has not commented on the removal of the initiative from the long term agenda, but has expressed a general opposition to regulating companies in response to societal pressures. The SEC may also have removed the item due to possible uncertainty concerning rulemaking authority. Or the SEC may have removed the item because it felt the legislative branch was better equipped for amending the Exchange Act.


Process Bylaws and the Internal Affairs Doctrine

There has been a great deal of ink spilled over the recent spate of bylaws coming out of Delaware that regulate process. Some dictate the forum where actions can be brought (specifying Delaware for the most post). Others provide for fee shifting bylaws. To the extent plaintiffs do not "substantially prevail," they may be required to pay the company's fees.

The bylaws are very different from those permitted in the past. These do not regulate the substance of the relationship between managers and owners, they regulate and interfere with the process involved in litigating underlying substantive violations. In theory, for example, they would allow a company to shorten the statute of limitations for filing a complaint or shortening the time period for filing or answering motions.  

A commonly used definition of the internal affairs doctrine is contained in Edgar v. Mite, a 1982 Supreme Court opinion. 457 US 624, 646 (1982) ("The internal affairs doctrine is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation's internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders—because otherwise a corporation could be faced with conflicting demands."). The doctrine recognizes that only one state should control the internal affairs of a corporation (matters "peculiar" to the relationship between "current" managers and owners) in order to avoid "conflicting demands."

The process oriented bylaws do not address "conflicting demands." The forum selection bylaws do restrict causes of action to a single jurisdiction but they are really designed to ensure that Delaware jurists are the decision maker. Fee shifting bylaws do not in any way implicate "conflicting demands" (particularly when applicable to federal causes of action) nor do they necessarily involve "current" managers and shareholders.

In short, these bylaws arguably do not implicate the "internal affairs" doctrine. To the extent that they do not, courts considering the application of the bylaws will not be obligated to give weight to the state of incorporation but would only be required to apply the law of the state that would otherwise have jurisdiction over the case under traditional choice of law principles.


SEC Revises Rules Governing Asset-Backed Securities

Spurred by the financial crisis in 2008, the Securities and Exchange Commission (“SEC”) has adopted revisions to the rules governing the disclosure, reporting, and offering process for asset-backed securities. The main goal of the revisions is, according to SEC Chair Mary Jo White, to enhance disclosure requirements and make it “easier for investors to review and access the information they need to make informed investment decisions” (Chair White Speech on Asset-Backed Securities). The revised rules should ultimately permit investors to conduct their own due diligence in assessing the risk of investing in asset-backed securities.

Asset-backed securities (“ABS”) are created when financial institutions buy and bundle loans (e.g.  mortgages, auto loans, and debt securities) into a package that is then marketed to investors. The bundles are often divided into separate securities with varying levels of risks and returns. The payments made on the underlying loans generate the returns paid to the ABS investors. The securities are assigned a certain risk rating by various credit rating agencies according to the securitization structure of the loan bundle. The financial crisis brought to light several problems surrounding ABS and the offering process, including: a lack of transparency and oversight, insufficient enforcement mechanisms, and inadequate time for investors to review available information before making investment decisions. The SEC began to reform the process in April 2010 by issuing revised rule proposals for ABS, even before the adoption of the Dodd-Frank Act.  Final rules were adopted last month.

The new rules governing asset-backed securities aim to enhance transparency, better protect investors, and facilitate capital formation in the securitization market. The rules include provisions that require issuers to

  • Provide investors with asset-level information in a standardized, tagged data format for certain asset classes;
  • Allow investors more time to consider transaction-specific information;
  •  Remove investment grade ratings for ABS shelf eligibility; and
  • Institute amendments to prospectus disclosure requirements and Regulation AB.  

The revised rules will be effective 60 days after publication in the Federal Registrar. Issuers are required to comply with the majority of the revised rules within one year of publication. Offerings of ABS must comply with the asset-level disclosure requirements within two years of publication.

For more information about the revised rules for asset-backed securities see:


S.D.N.Y. Upholds Strict Scienter Pleading Requirements 

In In re ShengdaTech, Inc. Sec. Litig., 2014 BL 222900 (S.D.N.Y. Aug. 12, 2014), the District Court for the Southern District of New York granted Defendants A. Carl Mudd and Sheldon B. Saidman’s (the “Defendants”) motion to dismiss a securities fraud complaint (“Complaint”).

According to the allegations in the Complaint, ShengdaTech, Inc. (ShengdaTech or Company) manufactured nano-precipitated calcium carbonate, an additive used in tires and other products. ShengdaTech went public in 2007 through a reverse merger with a shell company incorporated in Nevada. In 2008, the Company disclosed in SEC reports $824 million in net sales and $36.03 million in net income. For the same period, ShengdaTech disclosed in reports filed with the Chinese Administration of Industry and Commerce (“AIC”) only $9.5 million in net sales and a net loss of $2 million. In 2009, ShengdaTech reported $102.1 million in net sales and $23.1 million in net income to the SEC; $6.07 million in net sales and a net loss of $6.2 million to the AIC.         

The Complaint asserted that, in March 2011, KPMG HK, the outside accountant, informed the audit committee that there were “significant inconsistencies” in its findings and ShengdaTech’s records and that “management had misdirected, intercepted and/or otherwise interfered with [] confirmation requests and responses.” The board immediately formed a special committee (“Special Committee”), which included both Defendants, to investigate the issue. In April 2011, KMPG resigned as auditor. In resigning, the Auditor was alleged to have stated:

“[S]enior management of the Company had not taken, and the Company's Board of Directors had not caused senior management to take, timely and appropriate remedial actions with respect to discrepancies and/or issues relating to the Company's financial records that were identified during the course of the audit for the year ended December 31, 2010.”

In August 2011, counsel for the Special Committee presented an initial report that "confirmed material irregularities and/or inaccuracies in the financial records of the Company." The same day, the Special Committee authorized the filing of a petition for Chapter 11 bankruptcy.

A number of shareholders (the “Plaintiffs”) initiated suits against ShengdaTech and the Defendants, alleging, in part, that the Defendants violated Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 20(a) of the Exchange Act. The Defendants’ filed a motion to dismiss the Complaint as it dealt with them individually.

Securities fraud claims brought under § 10(b) of the Exchange Act and Rule 10b-5 have six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.”

Under the PSLRA, plaintiffs must plead a “strong inference” of scienter. Scienter in the Second Circuit may be established by showing the defendants had motive and opportunity to commit fraud or presenting “strong circumstantial evidence of conscious misbehavior or recklessness.” The inference of scienter must be “strong in light of other explanations.” Group pleading gives rise to a presumption that statements made in group-published information are “the collective work of those individuals with direct involvement in the everyday business of the company.”

The court found that the Complaint did not meet the strict pleading standard required to show scienter. A desire to sell ShengdaTech securities at inflated prices was a motive that could be applied to almost any corporate defendant and was, therefore, an insufficient motive to establish the required strong inference of scienter. The Complaint also, according to the court, lacked any specific allegation showing the Defendants had actual knowledge that the 2008 and 2009 filings were false.

The opinion further found that group pleading was inapplicable. Group pleading applied to individuals involved in the day-to-day management of an organization. By the very nature of their position as directors, however, the Defendants were not involved in day-to-day management. 

For the above reasons, the District Court for the Southern District of New York granted the Defendant’s motion to dismiss the claims against them. 

The primary materials for this post are available on the DU Corporate Governance website.


SEC v. Nocella: Executives not Barred for Improper Accountings to the FDIC

In SEC v. Nocella, Civil Action H-12-1051, 2014 BL 222069 (S.D. Tex. Aug. 11, 2014), the United States District Court for the Southern District of Texas declined to grant the request to bar two bank executives from serving as an officer or director at a publically traded company.

According to the Securities and Exchange Commission’s (“SEC”) allegations, Franklin Bank Corporation (“Franklin”) financed single-family and residential mortgages.  In 2007, during the brink of the economic downfall, many of the mortgages became past due. Franklin began offering loan modifications to borrowers through three different programs: Fresh Start, Strathmore, and Great News. Each program essentially offered past due borrowers an opportunity to make one payment to make their loan “current.” General accounting principles require a loan to be considered impaired when it is likely that a creditor cannot collect all amounts due. Franklin did not, however, report these loans as modified on its third-quarter public statements. As a result, the FDIC notified Franklin of the improperly classified loans, and Franklin reclassified some of the loans as “non-performing troubled debt restructurings.”

The SEC filed suit against Anthony J. Nocella, the chief-executive officer, and J. Russell McCann, the chief-financial officer.  The SEC’s suit sought to bar Nocella and McCann from holding an officer or executive position with any publically traded company. Nocella and McCann filed motions for partial judgment in their favor.

The SEC has the authority to ask a court to bar defendants from serving as an officer or director of a public company under certain circumstances.  15 U.S. Code § 78u(d)(2).  For a court to do so, there must be a violation of Section 10(b) of the Exchange Act and substantial evidence to demonstrate “unfitness to serve as an officer or director.” The court has discretion in this analysis and considers the defendant’s actions, as well as the (a)  egregiousness of the violation, (b) recidivism, (c) roles in the company during the fraud, (d) degree of scienter, (e) economic stake, and (f) likelihood of future violations.

The court determined Nocella and McCann did not significantly meet any of the factors.  With respect to scienter, for example, the court found the “defendants acted with no intent to defraud Franklin's shareholders and with no extreme departure from business judgment. When the FDIC disagreed with the Strathmore loan classifications, Nocella and McCann corrected Franklin's books to reflect its criticisms.”    

As a result, while recognizing that the Bank “improperly accounted for modified mortgages under their management,” the court found that it was “abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”   

The primary materials for this case may be found on the DU Corporate Governance website.


The Impact of Boilermakers’ Continues to be Felt: Utah Court Upholds Delaware Forum Selection Clause

In a recent decision (North v. McNamara, No. 1:13-cv-833 (S.D. Ohio Sept. 19, 2014)), the United States District Court for the Southern District of Ohio upheld a forum selection bylaw unilaterally adopted by the board of directors of Chemed Corp. after alleged wrongdoing but in advance of two suits seeking redress for such wrongdoing. In so doing, the court joined with courts in, among others, New York, Texas (Order Granting Defendants’ Motion to Dismiss Because of Mandatory Forum Selection Clause, Daugherty v. Ahn, Cause No. CC-11-06211), Illinois, Louisiana, and California that have ruled similarly.

The bylaw at issue Section 8.07 was adopted on August 2, 2013 and stated: 

  • Unless the corporation consents in writing to the selection of an alternative forum, a state or federal court located within the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the corporation, (ii) any action asserting a claim for breach of a fiduciary duty owed by any director, officer or other employee of the corporation to the corporation or the corporation's stockholders, (iii) any actions asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, the certificate of incorporation or the by-laws of the corporation or (iv) any action asserting a claim governed by the internal affairs doctrine, in each such case subject to such court having personal jurisdiction over the indispensable parties named as defendants therein. 


On August 5, 2013, Chemed filed a Form 8-K stating in part, that "[o]n August 2, 2013, [Chemed] amended its bylaws by adding a new section 8.07 which provides Delaware courts are the exclusive forum for certain actions. The full text hereof is incorporated by reference."

Several months later, a Chemed stockholder filed a derivative suit in federal court in Delaware alleging misconduct dating back to 2010. Shortly thereafter, a different stockholder filed substantially similar litigation in Ohio federal court. Invoking the bylaw, defendants moved to transfer the case to the Delaware federal district court.

The stockholder objected to the transfer, arguing the forum selection bylaw should not be enforced because 1) she did not knowingly and willing consent to the bylaw; 2) the bylaw was adopted for an improper purpose; and 3) forcing her to litigate in the United States District Court for the District of Delaware would be "seriously inconvenient."

The heart of the opinion addresses the first of the stockholders claims and firmly rejects it. Relying on and further strengthening the import of Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) the court rejected the stockholders argument that she had not consented to the bylaw.

The court noted: 

  • As in Boilermakers, the shareholders of Chemed consented to the Delaware corporate framework by buying shares in a Delaware corporation and agreeing to the certificate of incorporation that allowed the board to unilaterally adopt bylaws. The board acted in accordance with the contractual framework and the certificate of incorporation when it amended the bylaws to include the forum-selection clause. While the shareholders did not provide contemporaneous consent to the amendment, they previously chose to be bound by those bylaws adopted unilaterally by the board . . . . The fact that the shareholders are unsatisfied with the consequences of the application of the terms to which they agreed is an insufficient basis upon which to find the bylaw so inequitable that it should not be enforced.  

Similarly, Plaintiff's argument that she did not receive notice and was unaware of Bylaw 8.07 is unavailing. To the extent the notice argument is intended to address her ability to provide contemporaneous consent to the bylaw before its adoption, the prior analysis of this issue is equally relevant here. To the extent that she intends to further argue that she cannot be bound because she did not receive notice or become aware of Bylaw 8.07's existence before she filed her lawsuit, a plaintiff's personal failure to read or become aware of changes made to the bylaws does not make the enforcement of the bylaw inequitable or unjust. That is particularly true here given that Defendants have demonstrated that the corporation publicly disclosed the amendment to the bylaws just three days after its adoption and several months before Plaintiff filed her lawsuit, and Plaintiff has not shown otherwise. The Court finds that to be reasonable notice to the shareholders, including Plaintiff, of the adoption of Bylaw 8.07. 

In considering whether the fact that the alleged wrongdoing occurred before adoption of the forum-selection bylaw, the court noted: 

  • [T]he forum-selection bylaw does not become unenforceable simply because it was adopted after the purported wrongdoing. The Court agrees with the Boilermakers court that a corporation may enact a forum-selection bylaw that is reasonable and fair, even in circumstances such as those presented here, for the purpose of consolidating litigation—particularly litigation brought on behalf of the corporation—into a single forum to reduce costs and prevent duplication. Not only would such consolidation be in the interests of the corporation, it also would be in the interests of shareholders to have the issues resolved efficiently and consistently. Moreover, as discussed above, binding a shareholder to such a bylaw is not unreasonable or unjust given that the shareholders were on notice at the time they purchased their shares in the Delaware corporation of the broad powers conferred upon the board to make, adopt, alter, amend, or repeal the bylaws from time to time. As such, the Court does not find the fact that the claims arose primarily before the adoption of the bylaw to render that bylaw unenforceable.  

The court then made quick work of dismissing the stockholders remaining objections to the bylaw and ordered transfer of the action to Delaware. 

This decision, in combination with the fee-shifting bylaw cases in Delaware and elsewhere (discussed here and here) show the power of boards to have their say as to where intra-corporate litigation will take place and who will pay for it. 


In re Delcath Systems, Inc.: Court Finds Elements of Securities Fraud under §10(b) and 10b-5 Sufficiently Pled

In In re Delcath Sys., Inc. Sec. Litig., No. 13 Civ. 3116 (LGS), 2014 BL 179685 (S.D.N.Y. June 27, 2014) the plaintiff, Delcath Systems Group, brought a class action on behalf of all persons or entities that were shareholders of Delcath Systems, Inc. from April 21, 2010 to September 13, 2013 (collectively “Plaintiffs”). Plaintiffs sought remedies under the Securities Exchange Act of 1934 alleging that shareholders purchased Delcath stock in reliance on material misrepresentations and omissions made by defendants Delcath Systems, Inc. and its then CEO Earmonn Hobbs (together “Defendants”). Defendants moved to dismiss the complaint for failure to state a claim. The court denied Defendants’ motion because the complaint sufficiently stated a claim for relief under Section 10(b) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder. 

According to the allegations, Defendants filed a New Drug Application but were subsequently denied by the FDA. Defendants then submitted a revised application, which the FDA accepted for review on October 15, 2012. On April 30, 2013, the FDA published briefing documents, which stated that 7% of participants treated with the Melblez Kit died and 24% of the patients experienced serious side effects such as heart attack and acute kidney failure. None of the patients in the control group, however, died. Upon release of these findings, Delcath stock declined over 40%.

On May 2, 2013, the FDA met with the Oncologic Drugs Advisory Committee (ODAC) to discuss the Melblez Kit. The ODAC panel shared the same concerns as the FDA and voted against approving the Melblez Kit. As a result, Delcath stock declined another 42%. On September 13, 2013, the FDA issued a Complete Response Letter rejecting the Melblez Kit without further testing. In total, Delcath stock fell from $1.39 to $0.34 between April 30, 2013 and September 13, 2013.

Plaintiffs alleged that investors relied on Defendants’ misleading statements and omissions. First, Plaintiffs alleged the company and Mr. Hobbs made several overly optimistic statements regarding the likelihood of FDA approval. Second, Plaintiffs alleged Defendants made misleading statements about the safety of the Melblez Kit and failed to disclose the results of the control group in which no participants died.

Defendants moved to dismiss the claims pursuant to Federal Rule of Civil Procedure 12(b)(6). In order "[t]o survive a motion to dismiss, a complaint must plead enough facts to state a claim to relief that is plausible on its face." Furthermore, to allege a violation of securities fraud under Section 10(b) and Rule 10b-5, a plaintiff must plead: “(1) a material misrepresentation (or omission); (2) scienter, i.e., a wrongful state of mind; (3) a connection with the purchase or sale of a security; (4) reliance . . . ; (5) economic loss; and (6) loss causation."

In the present case, the court determined whether the complaint sufficiently pleaded three of the six elements: a material misrepresentation or omission, scienter, and loss causation. The court found the complaint sufficiently pleaded these elements with respect to Phase II Results Statements.  The court, however, found the complaint did not sufficiently plead that the statements made regarding the FDA’s approval were false and misleading.

In analyzing whether a statement or omission is materially misleading, the court must determine “whether a reasonable investor would have viewed the nondisclosed information as having significantly altered the total mix of information made available." Regarding the statements made about the FDA’s approval, the court found that Defendants did not express certainty that the Melblez Kit would receive FDA approval, and, therefore, those statements were forward-looking statements in conjunction with meaningful cautionary statements.  As a result, the statements fell within the safe harbor in the PSLRA and were therefore not actionable.   

As a result, the court denied Defendants’ motion to dismiss because the complaint sufficiently stated a claim for relief under the Section 10(b) of the Securities and Exchange Act and Rule 10b-5 promulgated thereunder.

Primary materials are available on the DU Corporate Governance website.


Biotechnology Value Fund, L.P. v. Celera Corp.: § 14(e) Claim Sustained by Sufficient Pleading of Non-Futility

In Biotechnology Value Fund, L.P. v. Celera Corp., No. C 13-03248 WHA, 2014 BL 55950 (N.D. Cal. Feb. 28, 2014), the United States District Court for the Northern District of California granted plaintiffs’ motion for leave to file a second amended complaint against defendants Credit Suisse, Celera, and Ordoñez (Celera’s CEO) with respect to plaintiffs’ Section 14(e) and breach of fiduciary duty claims. Additionally, the court denied plaintiffs’ motion to file a second amended complaint consisting of a Section 14(e) claim against the Celera directors (Ordoñez excepted), for failing to sufficiently plead their case.

According to the allegations discussed in the prior order from March 2010, Celera Corporation (“Celera”) and Credit Suisse Securities, L.L.C. (“Credit Suisse”) “signed the terms of an engagement letter” in which Credit Suisse would provide advising services to Celera, recommending “potential strategic transactions” for Celera. Credit Suisse’s compensation depended, in part, on whether Celera agreed to participate in any transaction. After various rounds of negotiations and several offers, Quest Diagnostics Inc. (“Quest”) and Celera executed an agreement whereby Quest would make a tender offer of $8 per share for Celera’s common stock. In March of 2011 Credit Suisse issued a “fairness opinion” to Celera’s board of directors, using a variation of a “Tufts study’s methodology,” describing the $8 per share offer as “fair.” As a result of this transaction, Credit Suisse “received a transaction fee of $8.6 million,” and Ordoñez, Celera’s CEO, “receive[d] a $2.3 million ‘change-in-control payment’ ” as well as other benefits from Quest.

Plaintiffs, former shareholders of Celera Corporation (“Plaintiffs”), filed suit, asserting claims under federal securities law, specifically under Sections 14(e) and 20(a) of the Securities Exchange Act, as well as under state law for breach of fiduciary duties, against Celera Corporation, Celera’s directors, Credit Suisse, and Kathy Ordoñez (collectively “Defendants”).

Section 14(e) requires a showing, at a minimum, that “defendants made a material misstatement or omission in connection with a tender offer.” Additionally, a “strong inference” of scienter must be shown. Defendants raised four challenges to Plaintiffs’ pleading in their § 14(e) claim, all of which the court denied.

In their second amended complaint, Plaintiffs alleged that Credit Suisse made misrepresentations in their recommendation statement to Celera in its present value calculation of Celera’s drug royalty assets. Credit Suisse argued that it did not “make” the misrepresentations: first, because it lacked “ultimate authority;” second, because Celera’s “statutory obligation to file the recommendation statement” precluded its liability; and third, because the statement was not made to Celera stockholders. The court found all three of these contentions unpersuasive. It stated that while Janus mandates that the “maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it,” there may be more than one party with ultimate authority over a given document. In so doing, the court found that the “descriptions of Credit Suisse’s valuation analysis are attributable to, and thus made by, Credit Suisse”—even though they appeared in the recommendation statement, which was created and distributed by Celera. 

Additionally, the court found that the amended complaint attributed the misrepresentations to Celera, but not to the Celera directors. The court stated that the second amended complaint focused on the fact that Celera had issued the recommendation statement, which contained Ordoñez’s signature and studies performed by Credit Suisse. The court determined that this alone did not make the Celera directors responsible for issuing the recommendation statement, and thus “[n]o alleged misrepresentation exists there for the Celera directors.”

Moreover, the court found that Plaintiffs had sufficiently pleaded scienter on behalf of Credit Suisse, Celera, and Ordoñez. To satisfy this requirement, a “ ‘strong inference’ of scienter is required, such that ‘a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.’ ” Based upon the allegations in the complaint, the court found that “Credit Suisse was financially motivated to pursue a complete acquisition of Celera . . . even at a lowered price, so that it could salvage a transaction fee.” In addition, the amended complaint sufficiently pleaded scienter “based on the timing of Credit Suisse’s errors in valuing the drug royalty assets.” Finally, the court found that the complaint satisfied the scienter requirement with respect to Celera and Ordoñez due to communication within the company indicating knowledge of the miscalculation.

The court thus dismissed the § 14(e) claim against the Celera directors, and ordered Plaintiffs to file their second amended complaint as against Credit Suisse, Celera, and Ordoñez.

The primary materials for this post are available on the DU Corporate Governance website.  


Bank of America to Pay $16.6 Billion in Record Settlement for Financial Fraud 

On August 21, 2014, the Department of Justice (“DOJ”) reached a $16.6 billion settlement with Bank of America and its subsidiaries (“BOA”) to resolve allegations that BOA mislead investors about the risks of subprime residential mortgage backed securities (“RMBS”) during the period leading up to the 2008 financial crisis. This resolution is the largest civil settlement with a single entity in American history. As part of the settlement, the Securities and Exchange Commission brought an administrative proceeding against BOA. See In re Bank of America, Exchange Act Release No. 72888 (August 21, 2014). 

In the settlement’s statement of facts, BOA made a number of admissions. For example, BOA admitted that:

  • During the second and third quarters of 2009, Bank of America did not disclose that there were known uncertainties relating to (1) whether Fannie Mae had changed its repurchase practices after being put into conservatorship, and the increasing number of overall claims and contested claims from Fannie Mae; and (2) the future volume of repurchase claims from monoline insurers and the ultimate resolution of monoline claims that Bank of America had reviewed and refused to repurchase, but had not been rescinded.

Exhibit A, In re Bank of America, Exchange Act Release No. 72888 (August 21, 2014). 

Of the record $16.6 billion settlement, $8.2 billion will be paid to settle federal and state civil claims related to RMBS and other types of fraud. BOA will also pay a $5 billion penalty to settle claims under the Financial Institutions Reform, Recovery, and Enforcement Act. Additionally, $1.8 billion will be paid to settle federal fraud claims related to the origination and sale of mortgages, $1.03 billion to settle federal and state securities claims by the Federal Deposit Insurance Corporation, and $135.84 million to settle claims by the SEC. BOA will also pay $943 million to California, Delaware, Illinois, Kentucky, Maryland, and New York to settle various state claims.

The remaining $7 billion will be used to assist the thousands of investors, including homeowners, borrowers, and communities, harmed by BOA’s misconduct. Further, BOA has agreed to place an additional $490 million in a tax relief payment account to help cover some of the tax liability that will be incurred by consumers receiving relief.

Under the settlement, BOA has agreed to hire an independent monitor to determine whether its obligations have been satisfied.  

The primary materials for this case can be found on the DU Corporate Governance website.


Director Independence and the "Threat of Removal"

In teaching director independence under Delaware law, the classroom analysis focuses on the types of relationships that will disqualify a director as independent. A director who is independent in fact, however, may not be in practice. While law faculty can provide a hypothetical example of this, it is not easy to show from an actual case. The facts in In re Cornerstone Therapeutics, Inc.  Stockholder Litigation, Civil Action No. 8922-VCG (Del. Ch. Sept. 10, 2014), however, may provide the requisite practical example.  

In challenging the independence of a special committee, plaintiffs alleged that certain directors did not qualify as independent. Shareholders challenged the independence of some of the directors by alleging the existence of prior business connections with the controlling shareholder. As the court described:   

  • [T]he Plaintiffs allege that [two of the Directors on the Special Committee] lacked independence in evaluating [the controlling shareholder's] offer due to their involvement with Phenomix Corporation, Inc. (“Phenomix”), a company that in 2009 signed a $191 million agreement with [the controlling shareholder]. At that time, [one of the Directors] was a director, and [the other Director] was the CEO and a director, of Phenomix, but by 2013 Phenomix was defunct and existed only to wind up its affairs. Although the Phenomix deal was consummated in 2009—several years prior to [the controlling shareholder's] February 2013 Offer Letter—and Phenomix was defunct by that time, the Plaintiffs contend that [the Directors'] relationships demonstrate that neither individual could have acted independently in evaluating the transaction. 

Unsurprisingly, the Chancery Court was unimpressed with these allegations. Id. ("The Plaintiffs’ allegations in the Amended Complaint—that prior business relationships call into question the independence of the Director Defendants—are, to my mind, weak.").  

Plaintiffs also, however, asserted that Directors on the Special Committee lacked independence because of a "threat of removal." Plaintiffs alleged that the controlling shareholder's "financial advisor reminded the Special Committee that [the controlling shareholder] 'as the majority stockholder of the Company, had the right to remove and replace all of the non-Chiesi directors and the Company’s senior management team.' ” Notwithstanding the "threat of removal," the Special Committee rejected the offer from the controlling shareholder and issued a counter-proposal.   

Despite the apparent lack of concern over the statement by the relevant Directors, the action was enough to call the Committee's actions into doubt. As the court reasoned: 

  • The Amended Complaint also alleges, however, that an agent of the controller, frustrated by the hard bargaining of the Special Committee members, explicitly threatened their removal from office. In addition to the relevance of that allegation to fair process, the threat raises questions about the ability of the Special Committee to act in the best interest of the minority, unconflicted by self-interest.

Thus, the prior business relationships were not enough to cast the work of the Special Committee into doubt but a statement reflecting a factual reality of the governance dynamics of the corporation, that was apparently ignored, was enough.  


Alibaba and Fee Shifting Provisions

The Alibaba IPO received a great deal of attention. The offering generated over $24 billion, the largest on record. Discussions of the offering also focused on significant corporate governance issues, including the authority of the Alibaba Partnership to select a majority of the directors on the board.

What did not receive much (dare one say "any") attention was the existence of a fee shifting provision in the Company's Amended and Restated Memorandum and Articles of Association (Alibaba is incorporated in the Cayman Islands). Article 173 provides:   

  • Unless otherwise determined by a majority of the Board, in the event that (i) any Shareholder (the “Claiming Party”) initiates or asserts any claim or counterclaim (“Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Company and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits in which the Claiming Party prevails, then each Claiming Party shall, to the fullest extent permissible by law, be obligated jointly and severally to reimburse the Company for all fees, costs and expenses (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the Company may incur in connection with such Claim. 

The provision has some unique aspects. It applies only to shareholder claims (not claims of former shareholders). The provision shifts fees in claims against the Company but not, apparently, against directors. Finally, the provision is avoided by a shareholder who obtains a judgment on the merits.  

The provision, therefore, presumably makes suits under the federal securities laws (but not, apparently, derivative suits) less likely. Moreover, while the provision does not appear to apply to derivative suits, these are already difficult to bring. As the Registration Statement notes, "shareholders in Cayman Islands companies may not have standing to initiate a shareholder derivative action in U.S. federal courts",  id. at 66, and "as a general rule, a derivative action may not be brought by a minority shareholder." Id. at 280.  

As for the federal securities laws, Morrison may impose barriers to the extent the Company does an offering in China and, as a result, is listed on a foreign stock exchange. In addition, the suits face barriers with respect to collection. As the Registration Statement notes:

  • Substantially all of our assets are located in China. In addition, most of our directors and officers are residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or our directors and officers, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

Whatever the impact, the provision was apparently not discussed in the Registration Statement, although its possible that I missed the description (the registration statement was 319 pages long with another 116 pages devoted to the financial statements).  


Waiting for Dodd-Frank Clawbacks 

SOX for the first time provided a provsion that allowed for clawbacks of executive compensation in certain limited circumstances. The provision sought to fill a serious gap in the corporate governance process. Fiduciary duties were sufficiently anemic that they failed to compel boards to seek to recover compensation paid on the basis of financial statements that later proved to be materially inaccurate. As a result, Congress was forced to imposed such an obligation, federalizing another aspect of corporate governance.  

Section 304 of SOX allows for clawbacks of performance based compensation following an accounting restatement "due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws." 15 U.S.C. 7243. The provision only allows for clawbacks of compensation paid to the CEO and CFO. Neither officer, however, need to have actually engaged in the relevant misconduct.

SOX, however, was a tepid effort. The provision essentially provided no enforcement mechanism for the failure of boards to clawback compensation following a triggering restatement. With no private right of action, the only source of enforcement was the SEC. The SEC has brought only a small number of claims seeking clawbacks, including one this week. See In re Yazdani, Exchange Act Release No. 73201 (admin. proc. Sept. 24, 2014) ("Respondent . . . shall, within 30 days of the entry of this Order, reimburse Saba for a total of $2,570,596 in . . . bonuses, other incentive-based or equity-based . . . compensation, and . . . stock sale profits pursuant to Section 304(a) of SOX.").  

Dodd-Frank, however, provided a second generation clawback provision. Specifically, Section 954 required listed companies to put in place a policy mandating that:  

  • In the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentivebased compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement. 

The policy, therefore, expanded the circumstances that would trigger a clawback and expanded the persons subject to the requirement. Most importantly, however, the provision imposed a burden on issuers to clawback the funds. Thus, clawbacks would cease to be a matter left to the limited resources of the SEC.

The clawback provision, however, remains an idea on paper, not one that has been put into practice. The provision requires SEC rulemaking. No rule proposal has yet to emerge, although the provision is on the SEC's rulemaking agenda. As the Unified Agenda states: 

  • The Division is considering recommending that the Commission propose rules to implement section 954 of the Dodd Frank Act, which requires the Commission to adopt rules to direct national securities exchanges to prohibit the listing of securities of issuers that have not developed and implemented a policy providing for disclosure of the issuer's policy on incentive-based compensation and mandating the clawback of such compensation in certain circumstances.  

Yet a proposal has not yet surfaced. Until it does, the limited resources of the SEC effectively means that clawbacks are likely to remain an important but under-utilized tool in ensuring proper corporate governance.

For a discussion of the clawback provisions under SOX and Dodd-Frank, see Financial Institutions, the Market, and the Continuing Problem of Executive Compensation


Fee Shifting Bylaws and the Smart & Final Stores IPO

Smart & Final Stores went public this week.  The Company raised $161.4 million at $12 per share. According to published reports, the final price was at "the low end of its expected price range of $12-$14."  

Interestingly, the Company looks to be the first corporation to do an IPO with a fee shifting provision in the Certificate of Incorporation.  As the Company's Certificate provides: 

  • Notwithstanding anything in this Certificate of Incorporation to the contrary, to the fullest extent permitted by law,  in the event that (i) any current or prior stockholder or anyone on their behalf (a “Claiming Party”) initiates any action, suit or proceeding, whether civil, criminal, administrative or investigative or asserts any claim or counterclaim (each, a “Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Corporation (including any Claim purportedly filed on behalf of any other stockholder) and/or any director, officer, employee or affiliate thereof (each, a “Company Party”), and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the applicable Company Party for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the applicable Company Party may incur in connection with such Claim.   

The provision applies to "any action, suit or proceeding, whether civil, criminal, administrative or investigative" filed by "any current or prior stockholder or anyone on their behalf.  The provision apparently applies to a cause of action under Section 11 of the Securities Act of 1933.  Indeed, a shareholder bringing a Section 11 claim would presumably have to incur the risk that the shareholder would have to pay the costs associated with challenging the bylaw.

The interference with federal causes of action may violate Section 14 of the 1933 Act.  15 USC 77n ("Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title or of the rules and regulations of the Commission shall be void."); see also Section 29(a) of the Exchange Act.  In Shearson, the Supreme Court noted that the provision applied to provisions that denied shareholder the ability "to enforce the statutory rights created by" the 1933 Act.  
Shearson/American Exp., Inc. v. McMahon, 482 US 220, 222 (1987).  The argument exists that a fee shifting provision that effectively prevents shareholders/investors from bringing suits under the federal securities laws is in fact a denial of the ability to enforce statutory rights.  

Perhaps recognizing the legal fragility of the provision, the Article included a savings clause.  

  • If any provision (or any part thereof) of this Article SIXTEENTH shall be held to be invalid, illegal or unenforceable facially or as applied to any circumstance for any reason whatsoever: (1) the validity, legality and enforceability of such provision (or part thereof) in any other circumstance and of the remaining provisions of this Article SIXTEENTH (including, without limitation, each portion of any subsection of this Article SIXTEENTH containing any such provision (or part thereof) held to be invalid, illegal or unenforceable that is not itself held to be invalid, illegal or unenforceable) shall not in any way be affected or impaired thereby, and (2) to the fullest extent permitted by law, the provisions of this Article SIXTEENTH (including, without limitation, each such portion containing any such provision (or part thereof) held to be invalid, illegal or unenforceable) shall be construed for the benefit of the Corporation to the fullest extent permitted by law so as to (a) give effect to the intent manifested by the provision (or part thereof) held invalid, illegal or unenforceable, and (b) permit the Corporation to protect its directors, officers, employees and agents from personal liability in respect of their good faith service.  Any person or entity purchasing or otherwise acquiring any interest in the shares of capital stock of the Corporation shall be deemed to have notice of and consented to the provisions of this Article SIXTEENTH.

What is somewhat surprising is that, given the possible effect of the provision on shareholder/investor causes of action, the Registration Statement contained only a thin description of the provision.  As the Registration Statement provided:    

  • Attorneys' Fees in Stockholder Actions.  Our certificate of incorporation includes a requirement that, to the fullest extent permitted by law, a stockholder reimburse us for all fees, costs and expenses incurred by us in connection with a proceeding initiated by such stockholder in which such stockholder does not obtain a judgment on the merits that substantially achieves the full remedy sought. This provision may have the effect of discouraging lawsuits against us or our directors and officers.

A more fulsome discussion might have included a specific mention of causes of actions that could be affected by the provision.  Such a discussion could disclose the impact of the provision on actions under Section 11 of the 1933 Act.  

A more fulsome discussion might have included an analysis of the legality of the provision.  This might include mention that the only case in Delaware to date to address validity involved a bylaw propounded by a non-stock company.  It also could include disclosure of the possibility that Delaware will legislatively invalidate these provisions.  

A more fulsome discussion also might include some discussion of the possible impact of such a provision on board behavior.  It is possible that, if the provision effectively eliminates or vastly reduces the number of derivative suits, boards will have a reduced incentive to ensure that their behavior is consistent with fiduciary obligations.  

A more fulsome discussion also might include some discussion of the possible impact of the provision on corporate disclosure.  It is possible that, if the provision effectively eliminates or vastly reduces the number of claims alleging false disclosure under the federal securities laws, companies will have a reduced iincentive to ensure accurate disclosure.